The Obama administration’s Home Affordable Modification Program for reducing mortgages of homeowners who owe more than their houses are worth has fallen far short of its objectives. Officials seem surprised by that outcome and blame the result on administrative problems. But, all along, the program’s bad economics doomed it to failure.
Home buyers take usually out mortgages that cover only part of the value of the houses they are buying. In other words, the house is worth more than the mortgage owed. This means that in the event a borrower defaults, the lender can, in most cases, be repaid in full by foreclosing on the house and selling it to someone else.
However, housing prices have fallen dramatically since 2006. By 2009, about one in four home mortgages was “under water” — the market value of the house had fallen below the amount owed on the mortgage, or, put differently, the home equity was negative.
Under President George W. Bush, the Federal Deposit Insurance Corporation, the Federal National Mortgage Association (known as Fannie Mae) and the Federal Home Loan Mortgage Corporation (known as Freddie Mac) all announced debt forgiveness or “loan modification” formulas. The Treasury Department under President Obama continued this policy with the Home Affordable Modification Program, part of its Home Affordable initiative, which replaced the Fannie and Freddie programs. The modification program alone was aimed at three million to four million mortgages.
These modification programs encourage lenders to reduce mortgage payments, so that each borrower’s housing payments (including principal, interest, taxes and insurance) are no more than 31 percent of the borrower’s gross income. The payments are to be reduced for five years or to whenever the mortgage is paid off (whichever comes first).
The amount of the payment reduction depends on the borrower’s income — the less he or she earns, the more the payment is reduced. For example, a borrower whose annual family income is $100,000 can get housing payments reduced to $31,000 a year; a borrower whose annual income is $50,000 can have the payments cut to $15,500 a year.
If the mortgage modification rules were actually followed, one implication would be that a family that earns $50,000 more in the year before the modification stands to pay an additional $15,500 a year for five years on housing payments — a total of $77,500. Adding $50,000 to your income adds $77,500 to your expenses: the mortgage lender gets more than 100 percent of your extra income! Economists call this a marginal “tax rate” that exceeds 100 percent, because the person earning that income is obligated to give all of it to a third party (the lender, in this case), and then some.
Economists may argue about how high tax rates should be, but we all agree that marginal income tax rates of 100 percent (or more) are terribly destructive. And the terrible incentives in the federal mortgage modification guidelines were known even before the Obama administration put together its program.
Because of its destructive economics, the modification program was proposing changes that were only marginally beneficial to borrowers and massively costly for banks. Assuming that banks understood this, I predicted that banks would pursue their own interest by randomly and arbitrarily refusing to modify most of their mortgages according to the program formula.
A year and half into the program, this is no longer just a theoretical possibility. The Associated Press reported that many borrowers say the modification program is a bureaucratic nightmare. The A.P. report said, “They say banks often lose their documents and then claim borrowers did not send back the necessary paperwork.” Instead of modifying three million mortgages and preventing their foreclosures, less than one-half million mortgages have been modified under the program, while about three million borrowers received foreclosure notices (see the latest report by the Office of the Special Inspector General of the Troubled Asset Relief Program).
Rather than overtly contradicting the Treasury by denying eligible borrowers, banks are encouraging borrowers to deny themselves by requiring those borrowers to endure deluge of paperwork.
Both the Bush and Obama administrations have run roughshod over incentives, and the housing market and the wider economy continue to suffer because of it. We can hope that economic policy might be different after yesterday’s electoral shake-up, but more likely we’ll be drinking old wine from new bottles.